Tricks or Treats in the Fourth Quarter?

Many of us are wondering why the stock market has been more of a trick to our investment holdings this year, questions Jim Trippon of China Stock Digest.

After dropping roughly 25% from its value on July 1, the US stock-market indexes have rallied for weeks on the hope that Europe would avoid full-blown economic collapse.

Yes, a collapse in the European currency and banking system was, and still remains, a very real possibility.

The announcement last week that the EU countries agreed to write down 50% of the value of Greek Treasury bonds confirmed that at least some positive action to deal with this crisis in Europe is occurring. This, at least for the time being, has injected a shot of adrenaline to the stock indexes around the world including here in the US

As you will see below, these events may result in many of your portfolios requiring adjustment.

Of course, the problems in Greece are not even close to being solved. One of the clearest indications that all is not "baklava and ouzo" in the land of the Acropolis is that the budget deficit in Greece continues to increase at an alarming rate (it is up roughly 15% year-to-date over 2010.)

The other problem is that Italy, Spain, Portugal, and Ireland all also have problems paying for their federal programs and Treasury bonds.

My view on the situation has been that when the financial markets have a serious risk of a major default, serious caution is in order. Most of us agree that it is better to exercise restraint and caution than to risk massive personal investment losses. But doing so when the markets have rallied the last few weeks is pretty tough.

So the million-dollar question is…what’s next?

The market action last week indicates that investors around the world want to rush back into stocks. This is a reversal of the market trends of the entire third quarter of 2011. This means that a number of the investments you may have held in your portfolios over the past three months—particularly some of the most defensive holdings—will need to be exited.

The most typical thing to expect next is a several-week phase that professional traders call "consolidation." Consolidation is a fancy way of saying "stocks almost never just go straight up."

As a practical matter, it means that there is no reason to "panic sell" when exiting any defensive positions (such as inverse funds) in your portfolios. The type of movement we have seen in the past weeks will generally be followed by several pullbacks to test recent support levels.

Translated into English…this means that it is more likely than not that the gains will fade a bit, as the market pulls back to confirm a bottom in the market from the rough patch we experienced in the third quarter.

So as a practical matter, at this point, two adjustments will be considered in most portfolios.

First, if you have defensive investment positions, such as inverse funds, you may want to unwind (sell) those holdings as consolidation occurs. If you are holding any inverse or defensive positions that are not currently profitable, the consolidation process will generally provide an opportunity to sell those holdings at a profit, as long as you do not panic sell.

Second, you will want to consider beginning to accumulate those types of stocks that will most benefit from the classic rotation process that occurs during bottoming cycles. If we are now, as it appears likely, beginning the completion of this bottoming process, the time to identify the new holdings and begin adding them to your portfolios is now.

The market is likely to remain volatile for the rest of the year. By remaining vigilant, we will make the best of these challenging times.